Testamentary Trusts and the Related Tax Benefits

paul-evans-partner-makinson-dapiceBy Paul EvansMakinson d’Ápice Lawyers, Newcastle.

The use of testamentary discretionary trusts has become more prevalent in estate planning due to their value in delivering asset protection and taxation benefits for beneficiaries under a Will.

Testamentary Trusts

A testamentary trust is a trust created under a Will, only taking effect on death.  A testamentary “discretionary” trust is a trust where the trustee can exercise discretion in the payment of income and capital of the trust to the beneficiaries. In many ways this type of trust operates in the same manner as a discretionary family trust.

The advantages of a testamentary discretionary trust stem from the trust structure where control is separated from ownership.

Under a simple “Mum and Dad Will” (that is, all assets pass to the survivor of the spouses and then on the death of the survivor, everything passes to the children) the assets vest absolutely in the hands of the nominated beneficiaries. Therefore the beneficiaries legally own and absolutely control the assets.

The thinking behind a testamentary discretionary trust is different.

Under this structure the ultimate control and legal ownership of the estate assets rests with the trustee. This means the beneficiaries do not legally own the assets of the trust; they merely have a right to be considered in the distribution of the income or capital of the trust. The trustee decides which beneficiaries will receive income and capital from the trust and in what proportions.

It is this testamentary discretionary trust regime which allows for some asset protection and taxation advantages.

A properly structured testamentary trust can place an inheritance outside the beneficiary’s estate in the event of bankruptcy as the assets are not legally owned by the beneficiary, they are owned by the trust. Trust assets are also unlikely to be subject to transfer to a spouse under a Family Court order under current law, but it should be noted that the Court may treat trust assets as a financial resource available to the beneficiary in determining property settlements.

Taxable income generated by the trust can be allocated among trust beneficiaries in a tax effective manner.  Each beneficiary pays income tax on his/her allocated share of income, according to his/her marginal tax rate.  Unlike income distributed to a beneficiary under 18 from an Inter Vivos Trust (a trust created during life, such as a family trust) which is taxed at penalty rates, beneficiaries of discretionary testamentary trusts under 18 years of age are taxed at standard adult rates, accessing the benefit of the $18,200 income tax free threshold and marginal rates thereafter.

Case Study

Robert and Elizabeth Armstrong have two children, Claire aged 5 and Penelope aged 7. Elizabeth died suddenly leaving assets of $500,000.00 (excluding the family home).

Elizabeth’s Will included a Testamentary Discretionary Trust under which Robert along with Claire and Penelope are potential beneficiaries.

The annual income of the Trust is $30,000 and Robert as Trustee resolves to distribute the income equally between Claire and Penelope.  As Claire and Penelope have no other income the payments to them are tax free.

If Elizabeth’s Will had not included a Testamentary Discretionary Trust the income of $30,000 would have been added to Robert’s taxable income as a teacher of $100,000. He would have paid tax of approximately $36,000 as opposed to tax of approximately $24,900 (on his salary). Thus, in one year alone the testamentary discretionary trust has saved the family $11,100 in income tax! ($36,000 – $24,900) (Figures are for purposes of illustration only).

The tax benefits outlined above are not limited to parents with children under 18 years of age.  They are also available to grandparents who are, for example, assisting with the payment of grandchildren’s school fees.

It is important to understand that Testamentary Trusts are intended to benefit your chosen beneficiaries and will provide no benefit to you personally. Testamentary Trusts in cannot be created retrospectively and must be included in the Will made before death.

Contact the author directly by email or by telephone.

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